Managing accounts receivable

Dr. Long Phi Tran

1
Objectives
— Trade credit
— The decision to grant credit
— Credit analysis
— Monitoring accounts receivable
— Account payable management

2
Introduction
— Granting credit generally increases
sales.
— Costs of granting credit
- Chance that customers will not pay
- Financing receivables

— Credit management examines the

trade-off between increased sales and
the costs of granting credit.

3
Introduction
— A firm’s credit policy is composed of:
- Terms of the sale.
- Credit analysis
- Collection policy

4
The cash flows of granting credit

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Terms of the sale
— The terms of sale include:
- Credit period
- Cash discounts
- Credit instruments

6
Credit period
— Credit periods vary across industries.
— Generally a firm must consider three
factors in setting a credit period:
- The probability that the customer will not pay
- The size of the account
- The extent to which goods are perishable

— Lengthening the credit period generally

increases sales.

7
Cash discounts
— Often part of the terms of sales.
— Tradeoff between the size of the
discount and the increased speed and
rate of collection of receivables.
— An example would be “3/10 net 30”
The customer can take a 3% discount if he pays
within 10 days
- In any event, he must pay within 30 days

8
The interest rate implicit in 3/10 net 30

— A firm offering credit terms of 3/10 net

30 is essentially offering their
customers a 20-day loan.
— Cost of trade credit

EAR = (1 + r)n – 1

— EAR = (1+3/97)^(365/20)-1= 74.35%

9
Example
— Your firm purchases goods from its
supplier on terms of 1/15, net 40.
What is the effective annual cost to
your firm if it chooses not to take
advantage of the trade discount
offered?
EAR= 15.8%= (1+1/99)^(365/25)+1

10
Credit instruments
— Most credit is offered on open
account. An open account transaction
is a sale where the goods are shipped
and delivered before payment is due.
This means that the only formal credit
instrument is the invoice, which is sent
with the shipment of goods, and which
the customer sign as evidence that
the goods have been received.

11
Credit instruments
— Promissory notes are IOUs that are signed
after the delivery of goods.
— Commercial drafts call for a customer to pay
a specific amount by a specific date. The
draft is sent to the customer’s bank, when the
customer signs the draft, the goods are sent.
— Banker’s acceptances allow a bank to
substitute its creditworthiness for the
customer, for a fee.
— Conditional sales contracts let the seller
retain legal ownership of the goods until the
customer has completed payment.
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Credit policy effects
— Revenue effects
- Delay in recelving cash from sales.
- May be able to increase price.
- May increase total sales.

— Cost effects
-Cost of the sale is still incurred even though the
cash from the sale has not been recelved.
- Cost of debt - must finance receivables.
- Probability of nonpayment - some percentage of
customers will not pay for products purchased.
- Cash discount - some customers will pay early
and pay less than the full sales price.

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Benefits of trade credit
• It is simple and convenient to use, and it has
lower transaction costs than alternative sources of
funds.
• It is a flexible source of funds, and can be used as
needed.
• It is sometimes the only source of funding
available to a firm.

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Trade credit vs. standard loans
— Firms offer trade credit because:
- Providing financing at below-market. rates is an
indirect way to lower prices for only certain
customers,
- A supplier may have an ongoing business
relationship with its customer. It may have more
information about the credit quality of the customer
than a traditional outside lender such as a bank
would have.
- If the buyer defaults, the supplier may be able to
seize the inventory as collateral.

15
The decision to grant credit: Risk and
Information
— Consider a firm that is choosing between
two alternative credit policies:
- The firm refuses credit.
- The firm offers credit.
— If the firm refuses to offer credit, the only
cash flow is:
Q0 ×(P0 – C0)
where
P0 = Price per unit received at time 0
C0 = Cost per unit received at time 0
Q0 = Quantity sold at time 0
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The decision to grant credit: Risk and
Information
— The expected cash flows of the credit
strategy are:
–C’0 × Q’0at the time t = 0
and h × Q’0 × P’0 at the time t = 1
The prime (‘) denotes the variables
under the second strategy.
h is the probability that customers will
pay.
-Q’o x C’o h x Q’o x P’o +(1+h)x0
Expected Cashflow
Pay money to
produce=>
Cash flow (-)
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The decision to grant credit: Risk and
Information
— The NPV of the cash only strategy is:
NPVcash = Q0 × (P0 – C0)
— The NPV of the credit strategy is:
h × Q′0 × P′0
NPVcredit = –C′0 × Q′0 +
(1 + rB)
— The decision to grant credit depends on four
factors:
- The delayed revenues from granting credit
- The immediate costs of granting credit
- The probability of repayment
- The discount rate

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Example of the decision to grant credit

— A firm currently sells 1,000 items per

month on a cash basis for $500 each.
— If they offered terms net 30, the
marketing department believes that
they could sell 1,300 items per month.
— The collections department estimates
that 5% of credit customers will
default.
— The cost of capital is 10% per annum.

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Example of the decision to grant credit
No Credit Net 30
Quantity sold 1,000 1,300
Selling price $500 $500
Unit cost $400 $425
Probability of payment 100% 95%
Credit period (days) 0 30
Discount rate per annum 10%
— The NPV of cash only = 1,000 x ($500 - $400)
= $100,000
(1+APR/n)^n-1=EAR
— The NPV of Net 30: (r) = discount rate
-1,300*5425 + (1.300×$500×0.95)/ in 30 days
→> (1 + г)^365/30
(1.10)^30/365 = 1 + 0.1
= $60,181.58 1 +n = (1 +
0.1)^365/30
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Example of the decision to grant credit

— How high must the credit price be to make it

worthwhile for the firm to extend credit?
— The NPV of Net 30 must be at least as big as
the NPV of cash only
1,300x P0' x 0.95
$100,000 = - 1,300x $425 + 30/ 365
(1.10)
30/ 365
($100,000 +1,300x $425) x (1.10) =1,300x P0' x 0.95

($100,000 +1,300x $425) x (1.10)30/ 365

P0' = = $532.. 50
1,300x 0.95

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The value of new information about
credit risk
— The most that we should be willing to pay for
new information about credit risk is the present
value of the expected cost of defaults:
NPV defaut =-C’ox Q’o(1-h) + $0/(1+rB)
NPV default = -C’o x Q’o x (1 - h)
The maximum amount you may lose because of
bad customers

In our earlier example, with a credit price of $500,

we would be willing to pay $27,625 for a perfect
credit screen.
C’o*Q’ox(1-h) =$425x 1,300x（1-0.95）=$27 625

=> Total amount of

+ 0/(1+r) money related to bad
-Q’o x C’o x (1+h)
Amount of money you produce Some customers

the product for bad customer customers

pay money 22
Example: One-time sale
— NPV = -v + (1 - π)P / (1 + R)
— Your company is considering granting credit
to a new customer. The variable cost per
unit is $50; the current price is $110; the
probability of default is 15%; and the
monthly required return is 1%.
— NPV = -50 + (1-.15)(110)/(1.01) = 42.57
— What is the break-even probability?
◦ 0 = -50 + (1 - π)(110)/(1.01)
◦ π = .5409 or 54.09% (1 - π): probabilities customer pay
you

-v (1 - π)P+ π x0
Customer don’t pay money 23
Example: Repeat customers
— NPV = -v + (1-π)(P – v)/R
— In the previous example, what is the NPV if
we are looking at repeat business?
— NPV = -50 + (1-.15)(110 – 50)/.01 = 5,050
— Repeat customers can be very valuable
(hence the importance of good customer
service)
— It may make sense to grant credit to almost
everyone once, as long as the variable cost is
low relative to the price
— If a customer defaults once, you don’t grant
credit again

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Future sales and the credit decision

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Total cost of granting credit
— Carrying costs
- Required return on receivables,
- Losses from bad debts.
- Costs of managing credit and collections.

— Opportunity costs (Shortage costs)

- Lost sales due to a restrictive credit policy.

— Total cost curve

- Sum of carrying costs and opportunity costs.
- Optimal credit policy is where the total cost
curve is minimized.

26
Optimal credit policy

At the optimal amount of credit, the incremental cash flows from

increased sales are exactly equal to the carrying costs from the
increase in accounts receivable.

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Optimal credit policy
— Trade credit is more likely to be granted if:
- The selling firm has a cost advantage over other
lenders.
- The selling firm can engage in price
discrimination.
- The selling firm can obtain favorable tax
treatment.
- The selling firm has no established reputation for
quality products or services.
- The selling firm perceives a long-term strategic
relationship.
— The optimal credit policy depends on the
characteristics of particular firms.

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Credit analysis
— Credit information
- Financial statements
- Credit reports on customer’s payment
history with other firms
- Banks
- Customer’s payment history with the
firm

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Credit analysis
— Credit scoring:
- The traditional 5C’s of credit:
Character, Capacity, Capital,
Collateral, Conditions
- Some firms employ sophisticated
statistical models.

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Example: Evaluating a change in credit
policy
— Your company currently sells its product with a
1% discount to customers who can pay cash
immediately. Otherwise the full price is due within
30 days. Half of your customers take advantage
of the discount. You are considering dropping the
discount so that your new terms would just be net
30. If you do that, you expect to lose some
customers who were only willing to pay the
discounted price, but the rest will simply switch to
taking the full 30 days to pay. Altogether, you
estimate that you will sell 20 fewer units per
month (compared to 500 unites currently). Your
variable cost per unit is $60 and your price per
unit is $100. If your required return is 1% per
month, should you switch your policy?

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Example: Evaluating a change in credit
policy
— To decide whether to change your policy,
compute the NPV of the change. It costs
you $30,000 to make the 500 unites. You
receive payment for half of the unites
immediately at a price of $99 per unit
(1% discount). The other half comes in
30 days at a price of $100 per unite. At
that point, you are starting over again
with the next set of product. Thus, you
can think of your cash flow in any 30-day
period as:

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Example: Evaluating a change in credit
policy
Now 30 days
Produce first set of 500
units at $60 apiece
Customers pay for 250
units at $99 apiece
Customers pay for 250 …
units at $100 apiece
Produce next set of …
500 units at $60 apiece
Customers pay for 250 …
unites at $99 apiece
Total …
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Example: Evaluating a change in credit
policy
— Under the new policy, your cash flows
would switch to:
Now 30 days
Produce first set of 480
units at $60 apiece
Customers pay for 480
units at $100 apiece
Produce next set of …
480 units at $60 apiece
Total …

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Example: Evaluating a change in credit
policy
— Execute:
NPV current = -5,250 + (25,000 - 5,250)/0.01= - 1,969,750
NPV new= -28,800 + (48,000 -28,800)/0.00 =- 1,891,200

—So the NPV of the switch will be:

$1,891,200 - $1,969,750 = -$78,850

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Example: Evaluating a change in credit
policy
— Evaluate: You should not make the
switch because you will lose too many
customers, even though your
remaining customers will be paying
the full price. The valuation principle
helps us weigh this tradeoff - the
present value of the costs outweighs
the present value of the benefits, so
the decision is not a good one.

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Question
— Your company currently sells its product with a 2%
discount to customers who pay cash immediately.
Otherwise the full price is due within 30 days. Sixty
percent of your customers take advantage of the
discount. You are considering dropping the discount so
that your new terms would just be net 30. If you do that,
you expect to lose some customers who were only
willing to pay the discounted price, but the rest will
simply switch to taking the full 30 days to pay.
Altogether, you estimate that you will sell 20 fewer units
per month (compared to 1,000 units currently). Your
variable cost per unit is $90 and your price per unit is
$150. If your required return is 0.5% per month, should
you switch your policy?

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Monitoring accounts receivable
— Accounts receivable days: The average
number of days that it takes a firm to collect
on its sales.
— Aging schedule:
- Categorizes accounts by the number of days
they have been on the firm’s books.
- Can be prepared using either the number of
accounts or the dollar amount of the accounts
receivable outstanding.
— Payments patterns: Provides information on
the percentage of monthly sales that the firm
collects in each month after the sale.

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Aging schedules

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Example: Aging schedules
— Financial Training Systems (FTS) bills its
accounts on terms of 3/10, net 30. The
firm’s accounts receivable include
$100,000 that has been outstanding for
10 or fewer days, $300,000 outstanding
for 11 to 30 days, $100,000 outstanding
for 31 to 40 days, $20,000 outstanding
for 41 to 50 days, $10,000 outstanding
for 51 to 60 days, and $2,000
outstanding for more than 60 days.
Prepare an aging schedule for FTS.

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Example: Aging schedules
— An aging schedule shows the amount
and percent of total accounts
receivable outstanding for different
lengths outstanding. With the
available information, we can
calculate the aging schedule based on
dollar amounts outstanding.

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Example: Aging schedules

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Example: Aging schedules
— FTS does not have an excessive
percent outstanding at the long-end of
the table (only 6% of their accounts
receivable are more than 40 days
outstanding).

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Problem
— Bubba s Bikes bills its accounts on terms
of 2/10, net 30. The firm s accounts
receivable include $5,000 that has been
outstanding for 10 or fewer days, $3,000
outstanding for 11 to 30 days, $2,000
outstanding for 31 to 40 days, $1,500
outstanding for 41 to 50 days, $1,000
outstanding for 51 to 60 days, and $500
outstanding for more than 60 days.
Prepare an aging schedule for Bubba s.
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Collection effort
— Most firms follow a protocol for
customers that are past due:
- Send a delinquency letter.
- Make a telephone call to the
customer.
- Employ a collection agency.
- Take legal action against the
customer.

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Late payment fees and prompt payment
discounts
— Late payment fees and prompt
payment discounts are incentives
designed to encourage customers to
pay according to terms. Prompt
payment discounts offer a reward for
paying “early”, and late payment fees
are a penalty for paying late.

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Factoring
— The sale of a firm’s accounts
receivable to a third party (known as a
factor).
The factor pays an agreed-
upon percentage of the
accounts receivable to the
Customers send firm. The factor bears the
payment to the Factor risk of nonpaying
factor customers

Customer Firm
Goods

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How to finance trade credit
— There are three general ways of financing
account receivables:
- Secured debt : Referred to as asset-based receivable
financing. This is the predominant form of
receivables financing.

- Captive finance company : Large companies with good

credit ratings often form a
finance company as a
subsidiary of the firm.

- Securitization : Occurs when the selling firm sells its

accounts receivable to a financial institution,
which then pools the receivables and sells
securities back by these assets.
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Payable management
— Determining accounts payable days
outstanding: Firms should monitor
their accounts payable to ensure that
they are making their payments at an
optimal time.

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Example: Accounts payable
management
— The Rowd Company has an average
accounts payable balance of
$250,000. Its average daily cost of
goods sold is $14,000, and it receives
terms of 2/15, net 40, from its
suppliers. Rowd chooses to forgo the
discount. Is the firm managing its
accounts payable well?

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Example: Accounts payable
management
— Given Rowd’s AP balance and its daily
COGS, we can compute the average
number of days it takes to pay its
vendors by dividing the average balance
by the daily costs. Given the terms from
its suppliers, Rowd should wither be
paying on the 15th day (the last possible
day to get the discount), or on the 40th
day (the last possible day to pay). There
is no benefit to paying at any other time.
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Example: Accounts payable
management
— Rowd’s accounts payable days outstanding is
$250,000/$14,000 = 17.9 days. If Rowd made
payment three days earlier, it could take
advantage of the 2% discount. If for some reason
it chooses to forgo the discount, it should not be
paying the full amount until the fortieth day.
— The firm is not managing its accounts payable
well. The earlier it pays, the sooner the cash
leaves Rowd. Thus, the only reason to pay
before the 40th day is to receive the discount by
paying before the fifteenth day. Paying on the
eighteenth day not only misses the discount, but
costs the firm 22 days use of its cash.

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Problem
— Bugs Bunny Baked Chicken (BBBC)
has an average accounts payable
balance of $300,000. Its average daily
cost of goods sold is $15,000, and it
receives terms of 2/15, net 25, from its
suppliers. BBBC chooses to forgo the
discount. Is the firm managing its
accounts payable well?

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Payables management
— Stretching accounts payable
- When a firm ignores a payment due
period and pays later.
- COD: Cash on delivery.
- CBD: Cash before delivery.

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Example: Cost of trade credit with
stretched accounts payable
— What is the effective annual cost of
credit terms of 1/15, net 40, if the firm
stretches the accounts payable to 60
days?

55
Example: Cost of trade credit with
stretched accounts payable
— First, we need to compute the interest
rate per period. The 1% discount means
that on a $100 purchases, you can either
pay $99 in the discount period, or keep
$99 and pay $100 later. Thus, you pay
$1 interest on the $99. If you pay on
time, then this $1 in interest is over the
25 day period between the 15th day and
the 40th day. If you stretch, then this $1 in
interest is over the 45 day period
between the 15th day and the 60th day.

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Example: Cost of trade credit with
stretched accounts payable
— The interest rate per period is $1/$99
= 1.01%. If the firm delays payment
until the sixtieth day, it has use of the
funds for 45 days beyond the discount
period. There are 365/45 = 8.11 45-
day periods in one year. Thus the
effective annual cost is (1.0101)8.11 - 1
= 0.0849, or 8.49%.

57
Example: Cost of trade credit with
stretched accounts payable
— Paying on time corresponds to a 25-
day credit period and there are 365/25
= 14.6 25-day periods in a year. Thus,
if it pays on the 40th day, the effective
annual cost is (1.0101)14.6 - 1 = 0.158,
or 15.8%. By stretching its payables,
the firm substantially reduces its
effective cost of credit.

58
Problem
— What is the effective annual cost of
credit terms of 2/10, net 30, if the firm
stretches the accounts payable to 60
days?

59
Academic papers about accounts
receivable management
— Soufani, K. (2002). The decision to
finance account receivables: The
factoring option. Managerial and
Decision Economics, 23, pp.21-32.

60
Soufani (2002)
— Factoring account receivables is an
economic decision whereby a
specialized firm assumes the
responsibility for the administration
and control of a company’s debtor
portfolio.
— It can be considered to be a method of
raising short-term capital based on the
selling of trade debts at a discount, or
for a prescribed fee plus interest.

61
Soufani (2002)
— The factoring market in the UK has been
growing steadily from both the supply
and demand sides. During the 1990s, it
recorded a 21% annual average growth
rate with a total turnover of about £48
billion. The factoring industry provides
working capital to over 25,000
businesses that employ more than half a
million people in the UK and is estimated
to contribute around 6% in additional
finance to SMEs.

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Soufani (2002)
— Despite the impressive development
of the factoring market, little academic
work has been conducted to explore
and evaluate the relationship between
the factoring industry and small-to-
medium size firms.

63
Soufani (2002)
— There are two types of factoring:
recourse factoring, which entitles the
factoring company to claim payment
directly from the client in the event
that a client’s customer defaults on
payment, and non-recourse factoring,
which does not involve such a
provision.

64
Soufani (2002)
— Data: 21 face-to-face interview with
executives of factoring companies.
— Size (number of employees): The
number of employees is not an
important parameter in the factoring
decision.
— Turnover: A firm’s annual turnover is
an important element in the decision
to supply credit through factoring.
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Soufani (2002)
— Product: Factoring firms consider the
product a firm sells or produces to be
very important.
— Industry: The industry feature did not
score highly on the scale of
importance as an influence on the
decision making process.
— Sector: The type of sector showed a
reasonable degree of importance for
the factoring decision.
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Soufani (2002)
— Age: The age of the client firm in the
market scored highly on the scale.
Age seems to be a proxy for
collectability.
— Customers: The client’s customers
scored very highly on the scale.
— Financial statements of the client
firms: The degree of importance
attached to the financial statement
was not high.
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Soufani (2002)
— The management team of the client
firm: Fairly important.
— Operational suitability: The likelihood
of avoiding disputes between the
client firm and the customers. This
aspect is not really important.
— Profitability: Profitability was not given
a high score on the scale.

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Soufani (2002)
— Collectability: The mean of this feature is
the highest.
— Credit notes: These are instruments that
allow their holders to claim financial
refunds, replace damaged items, or
items that did not meet the specifications
stipulated in the purchasing contract.
Many factors argued that if the credit
notes accounted for over 10% of volume
of sales then the business is
questionable. This feature is very
important.

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Soufani (2002)

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